Turning On The Lights: Deregulating The Market for Electricity

Studies | Regulations

No. 228
Friday, October 01, 1999
by Vernon L. Smith and Stephen Rassenti

Supply Companies

Creating a separate electric power supply industry is essential to deregulating successfully because it will address concerns about large power suppliers monopolizing some geographic markets.30 In addition to helping discourage antitrust action, divestiture will encourage the transition from regulated monopolies to competitive markets by driving down costs and attracting new entrants. Since much of the cost of electric service is related to generation, deregulating that end of the business will produce immediate and substantial benefits to consumers and open new opportunities to entrepreneurs.

"Having separate supply companies would remove any incentive for wires companies to discriminate among suppliers."

One way creating supply companies will drive costs down is by removing any incentive for wires companies to discriminate among suppliers once power prices are deregulated. Utilities that own both the power sources and the transmission and delivery facilities have incentives to favor their own power sources and discriminate against outside generators. Separating generation from transmission makes it more likely that competition, not regulation, will set the price of energy.

Why might electric utility companies embrace such a divestiture plan? Because states could require them to separate into wires and supply companies in order to get compensation for stranded assets.

Stranded Assets. Stranded assets are utility investments that, while apparently justified under regulation, are uneconomical under competition. The problem of stranded assets is political and is perhaps the most critical issue in deregulation. Conventional wisdom holds that overcapacity in generation has created assets whose depreciated cost, or book value, far exceeds their market value, but the problem varies greatly from region to region. Nuclear facilities, in particular, are believed to be unable to command market values commensurate with their book values. Estimates of the value of such assets range as high as $300 billion in an industry with $175 billion in shareholder equity.31 Thus utilities want some way of recovering the cost of those assets without distorting competition for marginal energy sources. They propose that their electric power consumers be assessed fees until the companies recoup their stranded costs.

However, we should not compound artificial price differences that arise from regulation. If a deregulation plan leaves each company to absorb uncushioned losses due to stranded assets, prices for some utilities' customers will escalate, worsening a problem deregulation is intended to solve. Separating stranded generation assets from newly formed wires companies would reduce and eventually eliminate such price differences, as explained below.

Determining Stranded Costs. Most proposals for dealing with stranded assets have called for a regulatory body to fix their value after a formal hearing, taking into account the utility's efforts to mitigate the impact of the assets on rates. This procedure has a dual disadvantage. First, the costs already are reflected in the utility's rates. Second, regulatory obligations are exactly what the transition to competition is supposed to phase out.

"The market should be allowed to determine the dollar value of stranded assets."

A better approach - addressing both views mentioned above - is to let the market determine the dollar value of the stranded assets. For the most part, these assets are related to the generation of electricity. Since divestiture would require the spin-off or outright sale of those assets by integrated utilities, generator value would be determined in the market by the price of new shares (in a spin-off) or by the successful bid (in a sale). Given the enormous importance of the electric power industry, buyers likely will emerge in great enough numbers to prevent price depression.

Although the book value exceeds the market value of some generation assets, this is not true of transmission or distribution assets. Acquiring new rights-of-way for transmission lines today is expensive or impossible. Thus the value of these assets will be substantially above historical costs if the rights to use the transmission system are permitted to reflect real conditions. Regulatory distortions have produced rates that overvalue a utility's generation assets and undervalue its transmission assets. This discrepancy in value can offset compensation costs for many stranded generation assets.

Some argue - although the power companies do not agree - that utilities have no right to recover stranded costs. They argue that air, rail and trucking companies were not reimbursed for such costs when they were deregulated. They also contend that government regulation does not confer a property right: when investors buy shares in a regulated industry, they gamble that regulations might be changed.

Others counter that while government limited entry and fixed prices in most regulated industries, it did not set prices to generate a specific return on capital. They contend this type of regulation gave electric utilities an extra incentive to make heavy capital investments.

Reconciling these sharply conflicting views is the greatest single challenge to deregulation of the industry.32 Because the political environment varies from state to state, utilities will differ in the form and terms of the bargains they seek to strike with regulators. Whatever the final arrangements, the objective of the utility will be to accept full deregulation and divestment of its generating assets in return for some form of compensation for a net capital loss, if any, on those assets.33 This could remove a major roadblock to the complete acceptance of deregulation and hasten the creation of market-based pricing and allocation of electrical energy. Several recent sales of generation assets have brought prices higher than depreciated costs. In these cases, so-called stranded costs turned into profitable assets.34

Competitive Pricing of Transmission. The overvaluation of generation assets and the undervaluation of transmission assets presents another market-based opportunity. Regulators can give utilities greater freedom to price both transmission and generation competitively. This will almost certainly lower the price of energy while raising the price of transmission in the short run. Competition would discipline both supply and transmission rates - supply by direct competition among sources, transmission by competition among rival paths and the ability of customers to bypass the electric grid by generating their own power. Any short-run abuse of market power in transmission would simply speed up the process of bypass.

"Competition would discipline both supply and transmission rates."

New Institutions. Creating supply companies will engender new market-based institutions. Supply companies will be free to sell electric power on a spot market resembling the commodities exchange or by contract with major buyers or any combination of the two. As discussed below, contracts should be financial hedges, with both parties bidding to buy or supply real power in the spot market. Competition in the wholesale market is spurring participants to devise new methods and institutions for trading power as a commodity. For example:

  • The Continental Power Exchange (CPEX), begun in July 1995, is a computerized electricity trading market that facilitates power transactions from participating entities coast to coast, and its trading volume already makes it one of the largest power markets in the world.
  • The recently chartered Automated Interchange Matching System (AIMS) includes more than 31 entities trading power from Florida into the North Central states.
  • The Western Systems Power Pool, begun as an experiment in 1990, has expanded to include power generators, marketers and utilities from British Columbia to Mexico and from the Pacific Coast to Georgia.
  • Wholesale electricity spot markets are now operating at several sites, and the Wall Street Journal carries daily price indexes.

These developments, along with the entry of hundreds of new companies into the electric business, show that even in a heavily regulated framework, markets respond to new opportunities. The contours of a future commodity market are well established in the supply business. If generation assets were sold or organized into stand-alone companies, these trends would accelerate.

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